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In addressing these questions, the natural response comes
rom
looking at each bonds asset swap level versus its reerence
nominal bonds one. This reerence bond is the one used to
calculate the ination breakeven. On the European Monetary
Union (EMU) ILB market, par/par asset swap is the market
standard.
However, depending on the adopted strategies, investors
could
nd this reading incomplete and not taking ully into account
the ILB market specics: impact o past ination, credit, repo
and
liquidity on asset swaps. At a time when markets are
reassessing
upwards the risks on all o these actors, measuring or at least
ully
understanding them beore entering into any asset swap
trading
strategies, appears even more important.In the EMU ILB market,
asset swaps are traded under the par/par
convention. This means that, when an investor buys 100M
asset
swap, he pays 100M or a 100M o the bond. He then trades a
swap
in which he pays back the bond ows against receiving 6M
Euribor
plus or minus a spread (asset swap level). He does not carry
any
directional risk but only credit risk in this trade. A negative
(positive)
asset swap level means that the credit rating o the bond
issuer
is better (worse) than the interbank market one. It is
thereore
possible to compare this asset swap level with the one seen in
the
nominal reerence bond to assess possible opportunities.
Looking
at the par/par asset swap spread (ILB asset swap nominal
asset
swap) o the EMU market, questions could nonetheless be
raised.
From par/par to net proceed asset swap
How does one explain that the asset swap spread on the OATei40
is positive, while negative on the OATei 32? Why is the asset
swap spread wider or France than or Italy on shorter
maturities
but narrower on longer ones (see gure 1). Going more in
depth
towards understanding the asset swap structure appears
necessary
beore taking the decision to invest in a bond.
By making the assumption that both the ILBs and the nominal
bonds trade at par, the par/par asset swap methodology does
not
take into account the act that the nominal o an ination bond
has already been inated since its issuance date. Let us
assume
ination has been 10% since the bond issuance. Buying 100M
ILB today, the investor would already get 110M o it. So the
bond
proceeds swap leg starts with a 110M nominal while the
Euribor
leg nominal is only 100M. As a consequence, issuance date has
an
impact on its asset swap level. The urther the bond issuance,
the
Calyon addresses the issue o considering infation-linked bonds
(ILBs) versus standard ones,
on a relative value basis. Are they cheaper? How to analyse the
spread between ILBs and
standard bond asset swaps?
How to read asset swap priceson infation-linked bonds
15/09/23
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stronger the impact on its asset swap, depending on past
realised
ination. Such a discrepancy does not exist on nominal bond
asset
swap. Correcting this actor and computing asset swap under a
net proceed methodology could thereore be a rst step in
better
understanding the asset swap market. In act, in the net
proceed
asset swap, the investor buys the bond at market price (x),
which
takes into account the inated nominal. The traded swap is
then
balanced (x millions nominal on both legs). Comparing ILB
with
its nominal reerence bonds is much more consistent with net
proceed method (see gure 2).
Credit and repo impact
However, even with the net proceed method, much remains to
be
explained, credit risk being a part o it. This actor also exists
in the
nominal bond market but, in the ination market, it is
amplied
by the structure o an ILB which is closer to a zero coupon. An
ILB
pays a real coupon, lower than the standard bond one, but on
an
inated nominal, which will be paid back at redemption. So,
the
biggest ow is paid at maturity as all o the ination
protection
since issuance is received at this time. Adding to this, between
the
various ILBs, the weight o the last ow inside the whole
coupon
structure could difer depending on the real coupon and the
anticipated ination to maturity. A high real coupon means a
high
annual coupon, which reduces in some way the weight o the
last
ow and thereore the credit risk. The more zero coupon-like
the
structure is, the more credit risk an investor carries. Finally,
the creditrisk is essential to understand and compare the asset
swap spread
(ILB nominal), rom one issuer to another. I the market
anticipates
the issuers credit to worsen orward, the credit risk impact will
be
negative as the zero coupon structure results riskier than the
one
based on an annual coupon.
Another actor worth taking into account is the repo impact,
which improves the nancing o bond positions. The repo does
not
trade at the same level on nominal or ILBs. Some
counterparties
reuse to take the latter as a collateral. As a result, in
standard
market conditions, the repo is worth around eonia -5bp on an
ILB
but eonia -10bp on its reerence nominal bond.
How to explain the corrected spread?
Taking into account the net proceeds method, the credit and
the repo impacts, the spread between ILBs and nominal bonds
asset swaps appears much more homogeneous than the one
traded in par/par asset swap. The gap between the net
proceeds
corrected asset swap spread o the OATei 32 and the OAtei 40
looks
narrower given that the OATei 32 has been issued well ahead
o
OAtei 40. One can notice as well that, corrected rom credit
and
repo impacts, the Italian net proceed asset swap spread curve
has
shited below the French one (see gure 3).
In order to explain the residual spread, liquidity is the
solution.
While the Euribor swap market does not sufer rom any
liquidity
gap, the situation is much diferent in the ination-linked swap
one.
This gap comes rom the act that, in the ination swaps
market,
the demand overwhelms the ofer. On the demand side, one cannd
all the bids coming rom the structured notes business. Adding
to this, there is the huge demand rom French nancial
institutions
seeking to hedge their risk on ination-indexed saving
accounts
(Livret A). This puts pressure on French ination 2-year to
15-year
orwards and, by contagion, on European ination orwards. On
the swap market supply side, project nance, utility and
local
authority interests are ewer and less requent. In addition,
when
there is no ofer o ination swaps, the market makers are led
to
buy ILBs, generating a long asset swap position In their books.
They
then have to sell back asset swap in the market. Hence, they
are
structurally on the ofer side o the asset swaps market. Because
o
this liquidity gap, ination swaps are more expensive and ILB
asset
swaps could trade signicantly cheaper than nominal bonds
ones.
Chose your own way of reading the market
Par/par asset swap reading is the market standard on the EMU
ILB
market. Having an inside view o the diferent actors
inuencing
the asset swap level o a bond is thereore important in order
to reach a conclusion on the richness/cheapness o one bond
relative to another. Investors could either choose to look at
one
reading or the other depending on the bet they make on the
issuer credit or the swap market liquidity. The longer the
strategy,
the stronger the impact o the investors bets on the return.
However, on the back o the current reassessing o risk
aversion
in the market, there is a need or more vigilance on all the
actors
impacting ILBs asset swaps.
SPONSORED STATEMENT
3 Corrected net proceed asset swap spread
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Georges SitbonHead o Ination andProperty Bonds and
Derivatives
T. + 33 1 41 89 98 29E. [email protected]
Frdric Prtet
Ination Desk StrategistT. +33 1 41 89 64 37E.
[email protected]
www.calyon.com
